The Decoupling Myth

As the European sovereign debt crisis flares up and the U.S. economy teeters on the brink of a double-dip recession, the question is how badly this will affect the Indian markets. The debate on whether we are still tightly coupled with the developed world markets, or have decoupled, has revived. Since India’s GDP growth is likely to be in the 7-8 per cent range while that of developed nations will be in the 1-2 per cent range or lower, will our markets continue to grow despite the troubles in the advanced world?
Proponents of the decoupling theory argue that global capital can’t lie idle: capital will seek out investments offering the highest rate of return. Since developed world equity markets have been underperforming, all that capital must be invested somewhere. What better place than high-growth emerging markets such as those of India?
Alas, things don’t quite work that way. While India’s high GDP growth rate is a hard fact, perceptions also count — the perceptions of those who control the money, that is, fund managers from US and Europe. India may have a high growth rate, but it is part of the emerging market basket. And in the perception of Western fund managers, emerging market equities are more risky than those belonging to the developed world.

Whenever risk aversion rises, money flows out of risky assets and into safe havens. Fund managers reduce their allocation to equities, and more so to emerging-market equities. In the most recent episode, money was pulled out of equities (especially that invested in “risky” emerging market equities) and invested in cash. And the preferred currency was the U.S. dollar. (The Swiss franc is also viewed as a safe haven, but money did not flow into it this time because the Swiss central bank has been doing its best to depreciate its currency in order to maintain the country’s export competitiveness.)
You may well smirk at the irony. How can emerging-market equities be viewed as risky compared to those belonging to the developed world when the former have delivered rock-solid GDP growth for a while now, while the latter have only anaemic rates to show?

Well, perceptions don’t change — at least not in a hurry. If the growth differential between the developed world and emerging economies continues for another decade or so (which is very much a possibility), emerging markets could well acquire the imprimatur of being less risky. No less a person than Jim O’Neill, chairman of Goldman Sachs Asset Management, who in 2001 coined the term Brics, believes this will happen. Till then we will have to live with huge outflows and the Indian markets swooning every time risk perceptions soar in the developed world. Moreover, this coupling exists not just between markets but between economies as well. India is a capital-scarce economy. (In fact, this is true of all the emerging economies: cumulatively they absorb capital to the tune of $1 trillion annually from the developed world.) Studies have found that a positive correlation exists between GDP growth in the US and investment demand in India. Whenever US GDP growth slows down, the capex cycle in India gets adversely affected — as is presently the case.
A second channel through which the fate of our economy is intertwined with that of the developed world is trade. It is true that in recent years our exports (of manufactured goods) have become more diversified. But US and Europe still account for a considerable 30 per cent of our exports. Moreover, many of our new export destinations — say, China and the South East Asian economies — themselves depend on US and Europe to absorb their exports. If these two blocs consume less, the impact will be felt by virtually every exporting nation. Furthermore, for service exports, chiefly IT-ITeS, we depend overwhelmingly on US and Europe. Remember that the service sector is the bulwark of our economy: it accounts for 55 per cent of our GDP, and is still growing at around 10 per cent while industrial growth has already faltered.
So the next time someone talks of decoupling, treat it as so much hokum. A revival of global growth is very much in India’s interests, so pray hard for it.

Working at cross-purposes
Fiscal policy is negating monetary policy
It is a classic case of one arm of the government working at cross purposes vis-a-vis the other. The Reserve Bank of India (RBI) continues to raise interest rates in order to reduce demand side pressures and allow prices to cool. Fiscal policy, on the other hand, remains far too loose. Justification for a loose fiscal policy existed in the aftermath of the global financial crisis. By bestowing spending power on people, the government’s stimulus packages staved off a sharp economic slowdown. Unfortunately, the fiscal spigot has continued to gush even after the crisis ended.
During the 11th five-year plan (FY07-FY12) the government has spent close to Rs. 6.5 trillion on its 12 flagship rural and social development programmes. To offer a comparison, this is equal to two years of the country’s fiscal deficit. In particular, the government’s decision to link wages in the MNREGA programme to the consumer price index (CPI) could prove expensive. Already MNREGA wages have set a floor on rural wages , which could result in many tertiary activities becoming uncompetitive.
Another measure that is stoking food inflation is the generous revision of minimum support prices (MSP) of food grains purchased by the government. Over the last four years, prices of pulses have been raised 70-90 per cent, that of rice 55 per cent, and of sugar 55 per cent. High support prices are one of the reasons why food inflation does not descend below a point in India.
Furthermore, government measures, once initiated, are nearly impossible to roll back. Future governments will be reluctant to de-link MNREGA wages from the consumer price index. So every year the outlay on MNREGA will keep getting bigger, and in tandem with burgeoning subsidy bills, make it difficult to bring the government’s fiscal deficit under control.
In future, whenever the government undertakes fiscal measures in order to shore up the economy, it should make them time-bound so that they lapse once they are no longer required.

Double dilemma
Manufacturing PMI indicates slowing growth and stubborn inflation
The signs of an economic slowdown are becoming more entrenched with each passing month. The manufacturing PMI (purchasing managers’ index), a leading indicator of manufacturing activity, has been constantly slowing down: from 57.5 in May it has declined to 50.4 in September. A figure above 50 indicates that the said activity is expanding. Manufacturing is still expanding, but only just. If the current downward momentum continues, then by next month the manufacturing PMI could well indicate contraction.
An examination of the sub-indexes further confirms the slowdown. The new orders index has declined sharply from 62.4 in May to 51.3 in September. It indicates that the sharp rate hikes by RBI over the last 18 months have taken a toll on demand.
The new export orders index has already plunged into contraction zone. It has stood at below 50 since July. Exports have been the one bright spot against an otherwise gloomy economic backdrop. They rose an exuberant 81.8 per cent y-o-y in July, and a more moderate but still substantial, 44.3 per cent y-o-y in August. What this index indicates is that export growth will slow down in future as global growth falters.
To turn now to two price-related indexes. At a high 62.1 for September, the input price index indicates that manufacturers face high input costs. The output price index stands at 55.5, which indicates that firms are not able to pass on their cost increases to customers fully. This will squeeze their bottomlines in future.
Thus, India is in a state of high inflation and slowing growth. It is to tackle this dual dilemma that RBI hiked the repo rate by 25 basis points on October 25 but expressed its concerns about slowing growth.